Develop New Methods for Managing Risk on the Islamic Risk

Managing risk is a crucial aspect of investment management. The Islamic capital market is developing rapidly. As its exposure to market risk (the very real possibility that the value of a security or group of securities can drop on any given day) increases, the market's inability to tap into certain conventional risk management instruments becomes more problematic. This article offers a quick overview of the concerns related to Islamic market risk and some products being developed to try to curb it.

Identifying the issues

Conventional investment funds have quite a few options for managing market risk, including futures, forward contracts, options, and swap markets. But the Islamic derivatives market is very small and very young. And in many cases, it faces restrictions from sharia boards that are wary of the speculation involved in derivative products as a whole.

Adding to the concern is that Islamic funds can't diversify as much as conventional funds. Their screening processes remove entire industries from investment consideration, narrowing the field of equity selection. Although diversification can't, by itself, eliminate market risk, it certainly can soften the blow when one large company — or even one entire industry — faces a sudden decline in equity value.

Creating products that mitigate market risk

Two groups of products are currently being developed to help hedge risk in the Islamic market: derivatives (specifically futures and forward contracts) and capital protected equity funds. Both types of products are familiar to conventional investors.

Futures and forward contracts

Futures and forward contracts are familiar derivatives in conventional finance. Both products are used to hedge risk, and both allow a buyer and a seller to agree today on the price of a future asset sale/purchase. (That asset may be a financial asset or commodity, for example.) A difference is that futures are traded on exchanges but forward contracts aren't.

Many sharia scholars have concerns about the compliance of derivatives in general. In fact, some scholars don't permit futures under any circumstances because these contracts involve goods that don't yet exist and therefore involve too much uncertainty. However, some scholars accept futures and forward contracts as sharia-compliant if the following conditions are met:

The delivery of the underlying asset is compulsory.

The delivery date of the asset can't be adjusted.

In Islamic finance, a salam (purchase with deferred delivery) contract is used to support futures and forward contracts. In a salam contract, the price of the goods to be received in the future is paid in full at the time of purchase. Therefore, this type of contract can be used to protect the value of assets in Islamic funds and Islamic bonds. This product differs from conventional futures and forward contracts, in which both the payment and the asset exchange take place in the future.

Capital protected equity funds

Capital protected equity funds require that the majority of assets in the funds be allocated to fixed-term cost plus murabaha contracts that are supported by third-party guarantees issued by A1/P1-rated financial institutions. (The financial institutions providing the guarantees have the highest short-term ratings from S&P and Moody's.) This product was introduced to help investors feel safer about their investments.

In the murabaha contract, the cost plus profit is deferred. When a fund is invested with such a contract, the investor receives profit plus capital in installments. Therefore, the fund is better able to return all the capital it invested.